Investing in shares that pay dividends is a popular way for people to earn extra income. Even some well-known blue-chip UK shares offer a high dividend yield.
This is how much an investor would need to invest to target a second income of £700 on average every single month.
How dividends can provide passive income
Dividends are money a company pays to those who own its shares.
They are never guaranteed. So, even though some companies pay four or more dividends to their shareholders each year, others pay nothing. A company that has been a generous payer before can stop suddenly, for example because they are earning smaller profits or decide to use the money on something other than paying dividends.
The quick way to forecast what a share will pay is what is known as dividend yield. It is the amount an investor could expect to earn each year from a share, expressed as a percentage of what they pay for it.
However, as dividends are never guaranteed, neither is yield. So just zooming in on high-yield shares can be a fool’s errand.
Whether a share currently offers a high yield, modest yield or none at all, the issue an investor ought to consider before investing is what they expect the payout to be (if anything) in the future, based on the company’s financial prospects.
One income share I own with a great track record
For example, one of the UK shares I own is drinks maker Diageo (LSE: DGE).
The Guinness brewer has an excellent track record, having grown its dividend per share annually for over three decades. However, that does not mean it will keep doing so.
Younger consumers are buying fewer alcoholic drinks than earlier generations did. Diageo has been struggling with weak demand in Latin America, while globally an uncertain economic outlook could hurt sales of premium-priced drinks.
Still, with unique brands in its portfolio and a proven business model, I reckon Diageo is down but not out. It has dealt with shifting consume tastes for decades already and is massively profitable. I have no plans to sell my shares.
Setting an income target
Share price weakness means the Diageo yield is now 3.9%.
That is above the average for leading UK shares (the FTSE 100 offers a yield of 3.5% currently) but is still well below what is available from a carefully chosen portfolio of quality shares.
In today’s market, I reckon a 7% yield is attainable (if not guaranteed). To earn £700 per month of income on that basis would require an investment of £120K.
Rather than putting in a lump sum (which is an option), an investor could start today from nothing, invest £400 per month and reinvest (compound) the dividends.
Doing that, after 15 years, they could have a portfolio valued at over £124K. At a 7% yield, that would generate over £700 each month on average as passive income in the form of dividends.
